Is Your California IRA Protected From Creditors? Probably Not.
A lot of folks in California, including probably a majority of professional legal and financial advisors, seem to think that Individual Retirement Accounts (IRAs) are either completely or partially exempt from creditors in the event of a judgment. Indeed, every year I end up reviewing a number of asset protection plans on a second-opinion basis for folks in California, and, sure enough, the involved planner will almost always have just blithely presumed that the client's IRA account will be an exempt asset not available to creditors. Today we will explore the validity of that presumption and find that it usually is not a safe one.
We begin with the exemption statute itself, being California Code of Civil Procedure § 704.115. Subsection (a)(3) tells us that a "private retirement plan" includes an IRA. Subsection (b) tells us that the assets of a private retirement plan are exempt while they are in the plan, and subsection (d) tells us that those assets are exempt upon distribution. Subsection (c), which I skipped, deals with exceptions to the exemption in the event of an alimony or child support order, which is beyond the scope of this article (suffice it to say that I have utterly no sympathy for those trying dodge any alimony or child support payments).
So far, so good. An IRA is exempt from creditors. Well, sort of, because that then brings us to subsection (e), which I have reprinted that subsection in full below. Recall that IRAs are deemed exempt under subsection (a)(3), and thus subsection (e) applies to them as discussed below.
"(e) Notwithstanding subdivisions (b) and (d), except as provided in subdivision (f), the amounts described in paragraph (3) of subdivision (a) are exempt only to the extent necessary to provide for the support of the judgment debtor when the judgment debtor retires and for the support of the spouse and dependents of the judgment debtor, taking into account all resources that are likely to be available for the support of the judgment debtor when the judgment debtor retires. In determining the amount to be exempt under this subdivision, the court shall allow the judgment debtor such additional amount as is necessary to pay any federal and state income taxes payable as a result of the applying of an amount described in paragraph (3) of subdivision (a) to the satisfaction of the money judgment."
There are two clauses in this subsection which are of great interest in determining if an IRA is exempt. The first clause is dangerous, and the second clause is really dangerous, so it is worthwhile to look at them in great detail.
The first clause to look at is that which provides that an IRA is "exempt only to the extent necessary to provide for the support of the judgment debtor when the judgment debtor retires and for the support of the spouse and dependents of the judgment debtor . . .." In other words: How much money will the debtor and the debtor's dependents need to live on in retirement? Suffice it to say that "the extent necessary" does not contemplate a luxury lifestyle in Beverly Hills, but more like somebody scraping by in a cheap apartment in an economically-challenged community.
How the courts make the determination of "the extent necessary" seems to litigators like myself to be almost random, as if the judge goes back into chambers and throws a dart at a board to come to a determination of what is exempt or not. Personally, I use my own rule-of-thumb in planning that an IRA that is less than $250,000 is likely to be protected, but amounts over $250,000 are likely to be lost to creditors. If you are curious where I came up with the number $250,000 — well, suffice it to say that the number is based rather evenly between my own anecdotal experience and my trusted OUIJA board.
But, even worse, this clause also requires some rough calculation as to the debtor's earning potential and their ability to rebuild their IRA back to some minimal value prior to retirement. If a debtor is relatively young, meaning under 50 for this purpose, then there is a good chance that a court will let a creditor collect on their IRA since the debtor has a chance of building it back later. In other words, if a debtor is under 50 and is employed, it is quite possible that none of their IRA will be protected from creditors. Conversely, if a debtor is nearing retirement, or is already in retirement, then their chances of building back their IRA go dramatically down, and thus it has more of a likelihood of it being exempt.
Some readers may be thinking by this time, "Whoa! The California Assembly could not possibly have been thinking that a court would have to peer into the future to see what a debtor might earn so as to build back their IRA." Well, that's exactly what the California Assembly meant, as indicated by the legislative comment:
"Subdivision (e) requires that the court consider all resources—such as social security payments and other income assets—that are likely to be available to the judgment debtor when the judgment debtor retires. Accordingly, where it will be a number of years before the judgment debtor will retire, the court will take into account not only all the assets of the judgment debtor at the time the exemption claim is determined but also all the assets and income (including pension rights) that the judgment debtor is likely to acquire prior to retirement."
That is the dangerous clause, and but now let's look at the really dangerous clause which upsets many an asset protection plan relying upon an IRA being exempt. That clause states that the aforementioned "the extent necessary" shall be determined by "taking into account all resources that are likely to be available for the support of the judgment debtor when the judgment debtor retires." The import of this clause is clear: The exemption for IRAs will be reduced on a dollar-for-dollar basis with all other moneys that will be available to the debtor in retirement. This approach has been validated by various court opinions, such as the one in In re Switzer, 146 B.R. 1 (Bk.C.D.Cal., 1992), where the court elaborated:
"IRAs may be exempted from creditor claims pursuant to C.C.P. § 704.115(a)(3). But any exemption of IRAs is limited by the terms of § 704.115(e) to sums 'reasonably necessary' to support a debtor and debtor's spouse in retirement. Trustee contends that none of the funds in Debtors' IRAs are reasonably necessary for Debtors' retirement. In analyzing whether sums Debtors seek to exempt are reasonably necessary for retirement, all of the Debtors' circumstances present and future must be taken into account , including potential disruption in earning capacity and the Debtors' ability to regenerate retirement funds.  Health care costs are an inevitable consequence of age that must also be included in the analysis.  Based on these criteria and the facts of a particular case, courts have considerable discretion in deciding what amounts are reasonably necessary for a debtor's retirement. [Internal quotation omitted]."
So, let's say that the debtor many years ago created and funded an asset protection trust for her own benefit, whether in Nevada or the Cook Islands or wherever, and that asset protection trust now has in it $2 million that the debtor can access, directly or indirectly, to fund the debtor's retirement. In that case, the amount of the IRA exemption available to the debtor is zero, since the debtor's retirement needs can be funded by the trust instead.
Or, let's say that the debtor has another fully-exempt plan on which she can draw on in retirement, whether a non-qualified California retirement plan, an ERISA plan, or the like, and which will fund all the needs of the debtor and her dependents. In that case, the debtor's exemption for her IRA will be zilch. In fact, this is the scenario which is the most common, in which a debtor has a fully-exempt plan running side-by-side with the IRA and presumes that the IRA is exempt in least in part two, when in fact it isn't protected at all. This in fact is what happened in In re Davis, 323 B.R. 732 (BAP 9th Cir., 2005), where the 9th Circuit's Bankruptcy Appellate Panel reasoned:
"The bankruptcy court did not mention at all the undisputed evidence that debtor will have a substantial exempt retirement fund to provide for her on retirement. Given the undisputed evidence about the value of that fund, as well as the fact that the errors in Fife's analysis that the court mentioned do not undermine his ultimate conclusion, we are left with a definite and firm conviction that the court erred in finding that the trustee had failed to meet his burden of proving that the exemption was not properly claimed."
I could go on and on with examples, but by now you should get the point: If the debtor will have available to her other moneys with which to fund her retirement, those other moneys effectively offset to a like degree the protection for any IRA that the debtor may hold. This is why you can't both do other asset protection for assets and presume that an IRA for a California client will be exempt, because that other asset protection will usually be the future source of funds that will work to negate the IRA exemption.
If there is any bright spot in subsection (e), it is that when the creditor does tap the IRA the amount the creditor can reach is restricted by the amount of tax fallout that the debtor suffers from having the IRA invaded, which presumably includes the 10% early-withdrawal penalty (but to the best of my knowledge we haven't had a court opinion which validates that yet).
There is also some sunlight to be found for debtors in the final subsection of § 704.115, being subsection (e), which provides that if the moneys paid from an IRA are payable periodically, then the payments are essentially treated as wages. This means that a creditor can only get up to 25% of the payments which constitute "net disposable income" (read: after tax, FICA, and any other withholdings). It gets more confused where there is a lump-sum distribution from the IRA, but in certain circumstances a percentage of that distribution might be protected as well. The bottom line is that under the right circumstances, up to 75% of the amount distributed from an IRA might be protected from creditors. However, it is not clear from the statute whether subsection (f) is determined after the exemption for the IRA itself is determined, or whether this rule applies only to the exempt part of the IRA upon distribution, and so we will probably have to wait for a future court opinion for clarification. I wouldn't want to be the test case on that one.
The upshot of all this is that the statutory creditor protections for IRAs held by California persons is very poor, and a person who is engaged in other asset protection planning at the same time should probably presume that their IRA will not be exempt. My own typical advice is to tell clients to quit funding their IRAs, and instead starting burning them down through withdrawals. Financial advisors and accountants typically don't like this advice much, since they are focused almost exclusively on the tax deferral aspect of IRAs, but ultimately it is the client who has to determine what makes the most sense for their particular situation.
Three court opinions in this area demonstrates just how all-over-the-board the results can be.
In re Switzer, 146 B.R. 1 (Bk.C.D.Cal., 1992). The debtor claimed as exempt about $600,000 ($1.19 million in 2022 dollars). Debtor was a 60-year old married male earning $120,000 working as the vice-president of a furniture company at the time of his bankruptcy, but he had health issues for which early retirement was a possibility, and his wife was unemployed. The bankruptcy court determined that if $500,000 of the debtor's IRA was protected, the debtor and his wife would receive total benefits (including social security payments) of $40,625 ($80,000 in 2022 dollars). Ultimately, the bankruptcy court ruled that $500,000 ($993,000 in 2022 dollars) was protected, but an excess of $100,000 was not, and that was taken by the bankruptcy trustee. As far as I am aware, the $500,000 protected in Switzer is the largest amount ever determined to be exempt under § 704.115(e), i.e., it is the high-water mark for IRA exemptions so far.
In re Spenler, 212 B.R. 625 (BAP 9th Cir., 1997). The debtor claimed as exempt $270,000 ($470,000 in 2022 dollars) in two IRA accounts. Debtor was a 55-year old single male who had no dependents and operated a his own medical practice. The bankruptcy trustee offered proof that the debtor's pension and social security would provide about $65,000 per year for him to live in retirement, and that he could also continue in his medical practice to around age 65. The bankruptcy court sustained the objection to the exemption, meaning that the amount of money protected in the IRAs was zero and they were emptied out by the bankruptcy trustee.
In re Davis, 323 B.R. 732 (BAP 9th Cir., 2005). The debtor claimed as exempt an IRA and two Keogh accounts containing $198,000 ($282,000 in 2022 dollars). Because the debtor had an exempt retirement plan which could provide for her retirement needs, the IRA and Keogh plans were determined not to be exempt.
The bottom line is that it is very difficult to predict what part of a debtor's IRA will ultimately determined to be exempt depending on the debtor's remaining years to retirement, needs in retirement, and other factors. What is not at all difficult to determine is that if the debtor's needs will be taken care of by an exempt plan, the IRA will not be exempt and thus not protected from creditors.